What is liquidity? Sounds weird right? Well, it’s not about a new craft beer or an energy drink! Liquidity is an interesting concept! It defines how efficiently or easily an asset can be turned into cash - while preserving its market value.
In accounting terms, liquidity is a way to evaluate if a business will be able to meet its short term debt!
It’s quite simple really. A business with high liquidity (lots of liquid assets) can more easily & quickly generate cash to pay debt obligations. On the other hand, a business with low liquidity (limited liquid assets) is at risk of running into cash flow issues when debts become due.
Liquidity is an economic concept that acts as a measure of how easily an asset can be turned into cash. In accounting, liquidity is a measure of a business's ability to pay off its short-term liabilities. Cash is the most liquid of assets.
Market liquidity defines if assets within a certain market can be bought or sold with steady and transparent pricing.
For instance : buying any asset will be easier and quicker with cash than if you had to sell off your art collection to do so, right? Well there you go! You just understood market liquidity!!
Obviously, the most liquid asset you can have is actual cash, as it is already available to be used at equal valuation. Other assets ranging from your company car, to real estate have different levels of liquidity.
Most liquid assets:
Least liquid assets:
Accounting liquidity is a measure of your business’ ability to honour short term liabilities, taking into account your current assets. It’s quite simple, bear with us!
Short term debt, or current liabilities are the amounts that must be paid to creditors within the year for taxes, bank loans, accounts payable, wages, lease payment. Sorry to remind you about all those by the way…
Current assets include your bank balances, the accounts receivable (the revenue you are still owed), and your liquid assets (available cash).
Liquidity can be measured with different ratios that can help you to assess the health and development of your company - such as solvency and profitability. But let’s stay focused on liquidity for now! It is after all the point of this article!
“Want a bit of knowledge to share with your friends? Just before the Renaissance, Italian bankers were the absolute bosses in the game. They used the term Liquido to qualify an easy, flowing, fast sale or transaction. The word buzzed hard, and it stuck! They were the business influencers of this time after all!”
In a few words, liquidity highlights the short term health of your company, and how much breathing room you have financially to meet your debt!
“Liquidity is used to qualify how easy it is to convert an asset into cash. Money in a bank account is the most liquid element for a company, because it can already be used to pay for things, right?”
Knowing your liquidity is very important to third parties too! How would you feel lending money to someone who owes more than they have? It's not 100% safe - that’s for sure!
It’s the same for your business! Liquidity is useful and insightful for you, sure! But it is also a great metric for others to assess your capacity to pay off debt in the short-term to banks and investors!
Eager to see how it’s done?
As often in the finance world, there are several ways to measure liquidity! The two main ones are the Current Ratio and the Quick Ratio.
So which one do I need then?
Well it depends on the industry and type of business you’re in, and most importantly how long it takes on average for you to sell your inventories!
“The stock of ground beef from the neighbourhood food truck is used to make burgers that are then sold. So it becomes cash relatively quickly! If, very differently, you sell luxury watches, they will surely stay longer in your store (unless you do not close your showcases)!”
If for instance you run a supermarket or a ashop that sells its stock fast, you will want to calculate your Current Ratio! It measures your current assets against l your current liabilities. Here’s the formula, but we also wrote a whole article about it if you want to find out more!
CURRENT ASSETS ÷ CURRENT LIABILITIES = CURRENT RATIO
If you sell high-end products (furniture, appliances, and such) you’re better off using e this metric! It still measures your ability e to pay off short term liabilities, but leaves out your stock.
The formula is below ! But, we also have a detailed article on this!
CURRENT ASSETS - INVENTORIES ÷ CURRENT LIABILITIES
Ok, so, in a nutshell, liquidity is calculated through different ratios which highlight if you have enough money to pay what you owe in the short-term.
Alright, is there a specific number to reach?
Mostly yes! For each ratio there are thresholds that your company should be above!
Concerning the Current Ratio, you should be aiming for 1.5:1 as a minimum. Above it you are considered to have sufficient liquidity. But sectors will influence the benchmarks! So compare your results to others from the same industry.
For the quick Ratio, you simply need it to be equal or above 1:1. At this point your company is liquid enough to honor its short term liabilities. As stockeis not included, it sums up what can be converted into cash quickly!
Also keep in mind that having a high ratio is good, sure! But it could also mean that your cash flow is poorly managed and could be put to better use!
Now that we know how to measure liquidity, we have a few tips for you to improve your liquidity.
This is a good way to boost your liquidity! For many companies, the time between the sale and the moment they receive the money can be days, weeks, and even months! If, say, a third of your customers pay their invoices late, it will influence your liquidity tremendously!
“Watch out for those friends! Poor management of customer receivables can have a huge impact on your liquidity! So set up a process for recovery and validation of the payments you are owed!”
This can also help improve your liquidity. If for instance you have several fancy offices or a fleet of company cars, your liquidity will be lowthrough the short term obligations they represent. Maybe it’s time to sell off some hard assets to turn them into liquid assets!
In both cases, having good liquidity should put you in a more confident position to either borrow or bring in capital. It means that you will be able to pay your debts and the interest to the bank. It means people investing in your business have a better chance of seeing their money back and/or being paid dividends.
We’ve just seen how important your liquidity is! But can you imagine the amount of time it would take to calculate it on a regular basis? And this is only one type of metric among many other ratios!
Today’s company leaders have limited time and better things to do!
Tax sheet here, invoices there… Oops, what about that excel sheet you haven’t updated in weeks. The One that doesn’t reflect your day to day reality anymore?
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“There are several ways to improve your liquidity! But the best thing is to make a cash flow forecast with all your data... You know it! You didn’t? Well now you know!”
Want to start a free trial and start managing your finances with ease? Or if you feel like you could use some help, why not ask for a demo?
“Le Khey de la compta”, literally “The accountancy bro” defines himself as the most irreverent accountant soon to be chartered by the public system. You can follow his funny tweets and posts on instagram @comptabeasy
Liquidity is used to qualify how easy it is to convert an asset into cash. Money in a bank account is the most liquid element for a company, because it can already be used to pay for things, right?
Here is a bit of knowledge to share with your friends? Just before the Renaissance, Italian bankers were the absolute bosses in the game. They used the term Liquido to qualify an easy, flowing, fast sale or transaction. The word buzzed hard, and it stuck! They were the business influencers of this time after all!
Actually nowadays in France, we still say “liquide” to designate cash money. And the English term cash flow also evokes this liquid notion. Feel smarter already?
You can start with receivables! It is the invoices not paid yet that can be converted into cash fairly quickly. For a lot of businesses, it’s over 1 or 2 months maximum. Watch out for those friends! Poor management of customer receivables can have a huge impact on your liquidity! So set up a process for recovery and validation of the payments you are owed!
Depending on your business, your stock will be sold at different speeds, and this is very important to take into account for your cash flow!
Example: The stock of ground beef from the neighbourhood food truck is used to make burgers that are then sold. So it becomes cash relatively quickly! If, on the other hand, you sell luxury watches, they will surely stay longer in your store (unless you do not close your showcases)!
There are several ways to improve your liquidity! But the best thing is to make a cash flow forecast with all your data... You know it! You didn’t? Well now you know!
Be a boss. Not an accountant.